Wednesday, October 4, 2017

Whatever Happened to Normalization?

What's become of the Fed's normalization plans? To get this straight, recall what's been abnormal about Fed policy for the last nine years or so. Here's a chart of the effective fed funds rate, and securities held outright by the Fed:

Abnormal policy began at the height of the financial crisis in late 2008, when the FOMC agreed on a plan to target the fed funds rate in a range of 0-0.25% - a policy that continued until "liftoff" in December 2015. As well, beginning in early 2009, the Fed embarked on a sequence of quantitative easing (QE) exercises, which increased the quantity of securities held outright by a factor of more than five. Further, the Fed got rid of essentially all of its Treasury bill holdings, and increased the average maturity of Treasury bonds and notes held. The Fed also purchased a large quantity of mortgage backed securities (MBS) - close to $1.8 trillion. So, the Fed increased the size of its balance sheet substantially, lengthened the average maturity of securities held, and departed in a big way from a policy of "Treasuries only."

As outlined in this FOMC document, the FOMC began thinking seriously about how Fed policy might return to normal, and what "normal" might be, as early as June 2011. A formal normalization plan was posted by the FOMC in September 2014, and this is essentially what has been implemented since, more or less. The plan was:

(i) Begin increases in the fed funds rate target.
(ii) Reduce the size of the balance sheet by stopping the reinvestment policy, after increases in the target policy rate are well underway.

Increases in the fed funds rate target began in December 2015, and we have since had three more, with the target range increasing from 0-0.25% to 1-1.25% currently. Balance sheet reduction did not commence until October of this year, when the FOMC issued an addendum to the 2014 plan. The addendum contains explicit details about how the balance sheet reduction will occur. Reinvestment - a policy by which assets in the Fed's portfolio are replaced as they mature, holding the nominal size of the balance sheet constant - did not stop abruptly, but its cessation will be phased in. It appears that the New York Fed did not purchase assets with a view to smoothing quantities that mature over time, and the FOMC seems concerned that the balance sheet not decline in a lumpy fashion, as it would without the caps on portfolio reduction outlined in the addendum.

Some questions that might come to mind (or should) on normalization, along with my answers:

1. Why did normalization start with interest rate increases first, then reductions in balance sheet size? It might seem logical, since QE followed the reduction in the nominal interest rate target to zero (effectively), that the Fed would normalize by first reducing the balance sheet to a normal size, and then increase interest rates. Indeed, there are some good reasons why this is what should have happened. As short-term nominal interest rates increase, the profit that the Fed makes on the spread between the return on its assets and what it is paying out on its liabilities declines. As a result the Fed makes a smaller transfer to the Treasury each year. QE took place in the context of relatively low yields on Treasury bonds and MBS, and with a larger balance sheet, the asset portfolio is being financed by a larger fraction of interest-bearing reserves and a lower fraction of zero-interest currency. If short-term rates go high enough, transfers to the Treasury will stop. Economically, this is unimportant, as this amounts to the difference between interest paid on reserves by the Fed vs. interest paid on government debt by the Treasury, but politically this could be very dangerous territory. The Fed should not give ammunition to its enemies in Congress. Added to this is the argument that QE was an experiment, with poorly understood consequences. Thus, the sooner the Fed ended the program, the better. So why not reduce balance sheet size before engaging in liftoff? Likely, because the FOMC was spooked by its experience in 2013. At that time, after the FOMC meeting that ended on June 19, Ben Bernanke announced that a winding-down, or "tapering" of the Fed's QE program was likely to being later that year, and that the program would probably end in mid-2014. The financial market response to that announcement, and earlier public statements by Bernanke, is sometimes called the "taper tantrum:"

In the chart, you can see an increase of more than 100 basis points in the 10-year Treasury bond yield, observable in both the nominal yield and the inflation-indexed yield. Somehow, this wasn't the response the Fed expected, but if the market viewed Bernanke's statement as news about forthcoming interest-rate target increases, the reaction doesn't seem outlandish in retrospect. In any case, this experience appears to have colored FOMC views on the importance of QE, and made them skittish about unwinding the program. Thus the idea that interest rate increases should be well under way before the Committee would even think about balance sheet reduction.

2. What's different about raising interest rates when the Fed has a large balance sheet? In theory, when there are reserves in excess of reserve requirements in the financial system overnight, the interest rate on excess reserves (IOER) should determine the overnight rate. This is called a floor system, under which interest rate control is easy, as the overnight interest rate can be essentially administered by the central bank. But in the United States, things aren't so simple. For the details see this article, and this one. Basically, there are regulatory features of the US financial system that restrict arbitrage in the overnight market, so that the "effective" federal funds rate is typically lower than IOER. And, as was also the case before the Fed began paying interest on reserves in late 2008, all fed funds trades don't happen at one interest rate on a given day - indeed, much of the fed funds market is conducted over-the-counter. The Fed was concerned, before liftoff happened, about its ability to achieve a given target range for the fed funds rate - would the fed funds rate even go up with increases in IOER? To assure that this would happen, the Fed expanded the market for its liabilities by making use of an overnight reverse repurchase agreement (ON-RRP) facility. ON-RRPs are loans to the Fed, usually overnight, secured by securities in the Fed's portfolio. These Fed liabilities are just reserves by another name - they can be held, for example, by money market mutual funds, which are prohibited from holding reserve accounts with the Fed. Currently, IOER is set at 1.25%, the ON-RRP rate is set at 1.00%, and on most recent days the effective fed funds rate is 1.16%. Here's a chart showing what has happened with Fed interest rate control since liftoff:

The chart shows takeup on the ON-RRP facility (quantity of ON-RRPs outstanding) and the effective fed funds rate. Initially, the Fed was willing to commit up to $2 trillion in collateral to ON-RRPs, but takeup is typically in the range of $50 billion to $250 billion, running up to $400 billion to $500 billion only at quarter-end (this for regulatory reasons). As well, the effective fed funds rate has recently been coming in consistently at about 9 basis points below IOER (except at month-end, again for regulatory reasons), and more detailed data shows that most trades happen around the average. In one sense interest rate control since liftoff appears to be a success. But it's not clear that the ON-RRP facility is necessary for its stated purpose. The fed funds rate might be about where it is now even without an active ON-RRP facility. We could go further though, and question this whole operating strategy. There is no good reason for the Fed to focus on a fed funds rate target. Fed funds are unsecured, and currently most of the trade in this market is just a means for some GSEs to earn overnight interest on reserve balances. Even in pre-crisis times, it would have made much more economic sense if the Fed had announced its overnight interest rate target as a target for an overnight repo rate. In the current context, why isn't the ON-RRP rate set equal to IOER? Maybe that would kill the fed funds market, but so what?

3. What happens to reserves when Fed assets mature and there is no reinvestment? The balance sheet of the Fed balances, just as any balance sheet does, so for any transaction that occurs affecting either assets or liabilities, implying a debit or credit, there must be an offsetting debit or credit. Suppose first that the maturing asset is a MBS. The issuer of the MBS - which would be a GSE if the MBS is held by the Fed - pays the face value of the debt to the Fed, and the payment will be made by reducing the balance in the GSE's reserve account by that amount. But the MBS that the GSE issued is composed of bits and pieces of underlying mortgage debt. Suppose that the reason the MBS matured was that the underlying mortgage debt was paid off. Then, mortage payments are made to the GSE, and ultimately those payments will involve an increase in the GSE's reserve balances, and a reduction in reserve balances held by private financial institutions. So reserves held by private sector institutions (a Fed liability) and MBS holdings (a Fed asset) decrease by the same amount. Suppose, alternatively, that a Treasury security held by the Fed matures. The Treasury holds a reserve account with the Fed, and a maturing Treasury security implies that the Treasury's reserve account balance (the account is called the "General Account") falls by the face value of the debt. But that has no implications for the private sector - it's just an accounting transaction between the Fed and the Treasury, like internal budgeting transactions between the English department and the Economics department at the University (if such a thing ever happens). There would be implications for the private sector if the Treasury, now finding itself short of reserve balances to pay for stuff, issues more debt to replenish those reserve balances. Then, the new Treasury debt is purchased by the private sector (the Fed won't be buying it, as it's not reinvesting) with reserve balances, so reserves held in the private sector fall. If you think about this a bit, you'll see that, if we think the level of of reserve balances held by the private sector is part of monetary policy, then the Treasury can engage in monetary policy, by varying the quantity of reserves in its reserve account. Look at this:

Note that both the level and variability of balances in the Treasury's general account have increased by a huge amount since the financial crisis. Maybe the Treasury thinks this doesn't matter now, as it won't mess with monetary policy, but that view is at odds with what the Fed says - which is that QE matters in a big way. If QE matters so much, then the big increase in average balances in the General Account in 2016 should have been a significant "tightening" (because it implies a reduction in privately-held reserves) that the Fed would be concerned with. What's going on?

4. When will balance sheet reduction stop? What the FOMC's normalization addendum says is that they don't know, so let me fill you in on what the issues are. The Fed needs to decide on a long-run operating strategy for monetary policy. They could adopt a channel system for monetary policy, like what Canada has, for example. This would involve operating with a small balance sheet. For example, in Canada, where there are no reserve requirements, overnight reserves are essentially zero. The target overnight rate in such a system is bounded by the interest rate at which the central bank lends (the discount rate, for the Fed) on the high side, and IOER, on the low side. Alternatively, the Fed could stick with the floor system under which it operates now, according to which there are excess reserves in the system overnight. The question then is how much reserves you need to make the floor system work. Basically, financial institutions have to be more or less indifferent between lending to the Fed overnight, and lending to to private entities overnight, so that the interest rates on Fed liabilities determine all overnight rates. Evidence from the Canadian experience from Spring 2009 to Spring 2010 suggests that number is smaller than some people seem to think. Probably less than $100 billion. In addition there are issues concerning what overnight rate the Fed should be targeting. In many countries the central bank targets a repo rate, which makes sense, as the central bank should be interested in a secured overnight rate, that is not contaminated by risk. Why persist in speaking to a fed funds rate target, particularly in a financial crisis?

5. Did QE actually work? Don't expect to get good information from the Fed about this. Central bankers want to at least keep up appearances. Who wants a central banker who's not knowledgeable and trustworthy? As I mentioned above, the Fed has many enemies - in Congress and elsewhere - and it's typically optimal for the institution if Fed officials don't admit to not knowing stuff. Truth is that I've never seen any solid evidence that the people who implemented QE in the Fed system actually have a grip on how it might work - either in theory or in practice. Bernanke once said that"QE works in practice but not in theory." I've heard that repeated many times, usually by a person with a smug look on his or her face. Basically, the statement's B.S. The evidence that QE works is weak or nonexistent. I've written about this in more detail in this St. Louis Fed article. Most of the pro-QE evidence comes from questionable event studies, and the evidence we have seems consistent with QE having no effects for the Fed's ultimate objectives. For example, the Bank of Japan has for more than four years engaged in a massive QE experiment that has had no discernible effect on inflation. And QE does in fact work in theory - at least in the 1950s and 1960s vintage theories that Berananke trotted out to justify the policy in the first place. More careful thought might make one think that QE could actually be harmful, by withdrawing useful collateral from financial markets and replacing it with inferior reserves (talk to people who understand "financial plumbing," for example Peter Stella or Manmohan Singh) It's possible that QE could do some good, if the Fed had the proper liabilities at its disposal. QE is basically an attempt by the central bank to engage in debt management, which is the job assignment of the Treasury in the United States. Maybe the Fed can do a better job of debt management than the Treasury, but if so there should be a public discussion, and an explicit assignment of tasks. And if the Fed is doing debt management it needs to be able to issue tradeable debt instruments of all maturities.

So, where are we? With the unemployment rate at 4.4% and the inflation rate at 1.3%, the Fed is achieving its goals, within reasonable tolerance. We're no longer in emergency territory, yet the Fed has an emergency-sized balance sheet. The plan they have issued to reduce the balance sheet is overdue, and it's quite timid. For example, note that during the QE3 program (the final stage of the Fed's asset purchase program), the Fed bought $85 billion per month in long-maturity Treasuries and MBS and that, even after a phase-in period, under the disinvestment program the reduction will be $50 billion per month, at most. Chances are that, when a recession comes along, the balance sheet will still be large, the interest rate target will quickly go to zero, and asset purchases will resume. If the Fed's balance sheet achieves any semblance of "normal" in my lifetime, I'll be amazed.

The one article you cite in support of your glib assertion that there is little evidence for QE effectiveness disagrees strenuously with your assertion. Never in the history of macroeconomics has a new and important question yielded such a universal strong empirical answer in such a short time. Even more studies are cited here: https://piie.com/publications/policy-briefs/quantitative-easing-underappreciated-success